Can We Have an Economy without Losers?

I’m getting the feeling that our government is trying to design an economy in which nobody loses. Is it possible to have an economy without losers? I don’t think so.

Despite President Obama’s attempts to transform what was a national credit party into a government rescue party, every economy has its share of losers. Ours can be no different. The government can intervene but by doing so, it will either make matters worse or at best shift the losses from one group to the next. Unfortunately, it seems that the Obama economic and political teams have decided to rescue almost every economic loser they can identify, with little regard for reality and the long term consequences.

Let’s explore this concept of natural losers in our economy by looking at unemployment, home ownership, and corporate survival.

Unemployment

Any respectable economist will tell you that eliminating unemployment in a market economy is not only impossible but undesirable. Economists recognize this concept as the “natural rate of unemployment.” This is the level of structural and frictional unemployment that will naturally occur in an economy that is not contracting or expanding at an excessive rate. (“Structural unemployment” is caused by a mismatch between the skills of those workers who are looking for jobs and the skills needed to fill available job vacancies. “Frictional unemployment” arises from workers looking to change jobs, from students entering the workforce, and from other former workers looking to re-enter the workforce.)

Estimates for the natural rate of unemployment in our economy range from 4%-6%. In other words, even when our economy is performing well, 4%-6% of the workforce will not be working, for one reason or another. There is no long term economic benefit in trying to change these numbers. If actual unemployment goes below its natural level, high inflation is almost certain to occur.

Home Ownership

This is one area where the government bears major responsibility for trying too hard to convert “losers” into “winners.” (Please note that I am not referring to “losers” in a pejorative sense but only to signify that certain people do not have a particular status in our economy that these people seek to achieve.)

Historically (and I mean going back decades), the home ownership rate in the U.S. hovered around 62% of households. Government activist policies pushed this rate upward beginning in the 1990’s, peaking at 69% in 2006. This represents an increase of about 6.7 million new homeowners. Guess what? That’s 6.7 million people who for one reason or another don’t need to be paying a mortgage and all of other expenses of home ownership. How do I know? Because now Obama is trying to rescue them. (For more on this, read “Taxpayers Crushed by the the Destructive Push for Home Ownership.” ) The point here is that 62% of U.S. households probably are OK owning homes but the other 38% are not. Trying to change that in our economy has proved to be a huge mistake. Those who were not qualified (under market conditions) to own homes made matters worse for themselves and for the economy as a whole by defaulting.

Corporate Survival

The government has decided that Freddie Mac, Fannie Mae, AIG, GM, Chrysler and a bunch of banks are all “too big to fail.” Billions in taxpayer dollars have been thrown at these companies. To what end? Millions of businesses fail every year in our economy. They are the market losers who were defeated by market winners.

“But we can’t let a car company fail!” Yes we can. It has happened many times before. Many of them you probably never heard of: DuPont, Pierce Arrow, Packard, Studebaker and Cord all went under earlier in the 20th century. In the ’80s, American Motors failed because of a string of awful cars. Its remaining pieces were folded into Chrysler. New car companies took their place. Kia and Hyundai are two relatively recent examples. That’s what happens in a competitive marketplace.

“But Mr. ToughMoneyLove, this time its different. The problem is so big the government must intervene.” I’m not going to spend any more time debating this because the Obama team is single-minded about aggressive rescues being the only solution. And they have the votes.

I agree that the unemployment rate is too high. And yes, the government should strategically attack that problem. After all, the government helped to cause it. But the government has overreacted to the unemployment problem by massive spending in other areas, e.g., targeting other economic “losers” through a myriad of new programs and rescues.

The government may succeed in its high energy mission to convert a wide variety of today’s economic losers into non-losers. But I contend that by doing so, the government will have created three new groups of economic losers: the next generations of taxpayers, consumers, and investors.

First, tax rates are headed up – way up, starting with the higher tax brackets. That announcement will come this week. Then the Bush tax cuts will be allowed to expire but I don’t think it will end there. Obama understands the need to control future deficits. His weapon of choice is more taxes.

Second, inflation and devaluation of the dollar are almost certain to follow, as the bills come due for all of today’s deficit spending. This will reduce consumer purchasing power as incomes struggle to keep up. What follows next won’t be pretty. For one, Social Security is tied to the cost of living. More payroll taxes will be needed to fund those cost of living increases.

Third, massive government intervention into the fiscal affairs of private businesses and homeowners could prolong the natural effects of economic failure. We could experience a “lost decade” like Japan did in the 1990’s, with the markets returning nothing. Retirees have suffered and future retirees will continue to suffer from this.

A more extreme example of government working to eliminate economic losers is the old Soviet Union and its never ending “five year” economic plans. We know how that turned out. I’m not suggesting that’s where we are headed but clearly we’ve taken some giant leaps in that direction.

Nobody enjoys watching others experience economic pain. But some pain must be tolerated in a market economy. Extending that pain or shifting it to others in a futile attempt to eliminate economic losers is bad government policy.

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I couldn’t agree more. A free market economy is based on competition, and often competition is a zero sum game. You would like to sell your house, stock, product at the highest price, and I would like to buy it at the lowest. Market forces set prices and determine winners and losers in this way. Posner and Becker both make compelling arguments for allowing the auto companies to file for bankruptcy over at their blog. Check it out if you get a chance. – Todd

Yesterday you were complaining that Obama’s home foreclosure plan wasn’t intended to save all people in risk of foreclosure. Personally I haven’t seen any sign that this administration is trying to save everybody. When true unemployment is up around 14%, something is significantly out of whack. All I’ve seen so far is them trying to address stuff like that. Let’s wait until we have single digit employment again before we start complaining that the government is trying to save people who it can’t/shouldn’t save.

Curt: Thanks for the biblical perspective. I need to do more reading in that area!

Todd: Where can I read the Posner and Becker commentaries?

TMN: Yesterday I was complaining that the foreclosure plan won’t work for the reason that it can’t save the unemployed from foreclosure. And, I am not just speaking about the unemployed. The government is trying to save business losers as well.

I am going to have to disagree with your comments, and even be somewhat dismissive (my apologies for that in advance). I will say that the information you are providing is absolutely correct and a fine read – in a vacuum.

Free Market like communism only looks good on paper and does not account for the “human” factor.

In our society, we try to balance between the positive elements of the Free Market ideology with the positive elements of socialist thinking. Before you start calling me a pinko communist, let me point you to the firecracker industry in India. In India you have a business that poisons the land, kills villagers, and employs children because of their nimble hands and resistance to the toxins associated with putting together fireworks. While there are people that are outraged by this behavior, many in the village just accept it as their lot in life (and at least we have jobs). Google it, if you are in doubt.

The point being that Free Market principles must be tempered in such a way as to suppress the urge to exploit people. On the other hand, we must resist the urge to become a country that provides no incentive for innovation, and success.

There is the proverbial pendulum that swings from one extreme to the other. I think we can all agree that the pendulum went too far with respect to business needs over the last few years, and that we are now seeing that pendulum starting to swing the other way.

As for the protection of the Big 3, the ripple effect of letting those businesses fail would be enormous. While I despise keeping zombie banks and zombie businesses afloat, I recognize the ramifications and weigh it against our long term interests. Something you do not do in your post.

Marc: I’m not sure I understand your comment. I agree that in many economic transactions both parties are winners. In an economic environment, there are always winners and some losers.

Rick: The human factor is important and I do not encourage relaxation of workplace and environmental safety standards which is the issue with your India fireworks example. But that is far different from a social engineering experiment in which the government tries to put unqualified people in homes, fails, then re-doubles its efforts in a doomed mortgage rescue plan. The big 3 (or two of them) have failed. The market has decided that. The government can help those who are displaced by that failure by not throwing more money down a corporate rat hole. AIG is getting ready to report a $60 billion loss. Do we continue to prop up that sinking ship?

Japan is a really good example of what can go wrong. They too had a real estate crisis. They too turned to tax hikes on the wealthy as we are trying to. To what end, long term economic contraction that they were only able to counteract by increasing exports. An option we don’t have because we are in the midst of a global recession, or at least trending toward it. The economy can benefit from government intervention, but government intervention is not a universal band-aid for those who the market would naturally kick out.

Do you think that social engineering resulted in our current dilemma? You believe that our government forced big financial institutions to put unqualified people into houses? ROFL! Come on Tough, you can’t really believe that load of cow manure?

Here are my thoughts: real estate market is booming, and financial institutions are scrambling to buy into double and even triple digit growth where the only downside is that if the loan defaults you are left with property worth more than the originating loan (which you can then turn around for even more profit). The bizarre assumption is that this trend will continue indefinitely, so common portfolio practices such as managing your risks go out the window along with the morality of rating agencies. And when it all blows up, just blame it all on social engineering?!

In so far as to your foreclosure comments, it really is hard to send billions to AIG and their ilk only to see them pat each other on the backs, and not try to give a hand to the ordinary person. It may not work perfectly, but given the fact that President Obama is probably going to have to tap more goodwill on behalf of these greedy nut jobs, it is probably worth every penny.

As to letting organizations fail that the market deems unworthy, it sure makes for a good sound bite! Unfortunately, I am not sure the markets will cheer while American unemployment rises into the 20-25% range.

My point is this Tough, just because it makes a good sound bite, and it looks good on paper does not a good idea make. Sometimes you have to go against the grain for the common good, and that is where we find ourselves today.

It helps me to think of this time as something akin to my time in college. I was living frugally, and definitely deficit spending my way to a degree (no Mom and Daddy money for me). The thinking being that if we invest in ourselves and our future that our deficit spending will yield sizable returns.

In conclusion Tough, we are investing in Americans and American companies (despite the fears of many) in hopes that they will rise to the level of our faith.

Rosa: I agree that Japan is a place to look for what can happen to us if we don’t learn from their mistakes.

Rick: I indeed believe that the government was complicit in social engineering us into this mess. Lenders in so called “red-line” neighborhoods were threatened and bullied into lowering their underwriting criteria to make loans in those neighborhoods. Those are the same neighborhoods now blighted by foreclosure. Congress (Barney Frank comes to mind) protected and encouraged Freddie and Fannie to continue its high risk lending and re-packaging activities. How do you think that we added so many new homeowners to the rolls? It wasn’t by accident.

Tough,
If you think the “red line” communities sucked trillions out of our economy then I don’t really know what to say.
Having worked for Wells Fargo for twelve or so years, I can say without the least bit of hesitancy that focus on short terms gains combined with favorable loan ratings (I would be interested to see how you explain social engineering affected rating agencies, but I digress) contributed far more to this calamity than anything Barney Frank did (though I have no respect for the man). Things were so competitive I would not be surprised if we discover whole swathes of homes owned by cadavers.
-Rick Beagle

MR TML, you state:
“Lenders in so called “red-line” neighborhoods were threatened and bullied into lowering their underwriting criteria to make loans in those neighborhoods.”

Maybe Joe the “Plumber” would buy this one hook, line and sinker but don’t you think your readers are a little bit more sophisticated than that?

I suggest you listen to the radio program “The Giant Pool of Money” produced by This American Life in collaboration with NPR (or you can read the transcript). They have interviewed mortgage brokers, bankers and the Wall Street types and none of these guys suggest that it was the government who put a gun to their head to make them give out those “liar” loans. Instead it was their own greed – some of those involved were making $75000 to $100000 a month! Under those conditions,do you really think they had to be threatened by anybody?
I understand that you don’t like President Obama and the Democrats but try to stick to the facts, otherwise your blog will start losing credibility
-FV

Rick: I am not letting the banks, the syndicators, or the ratings agencies off the hook on this. My point is that the government played a significant and blameworthy role in the mess we are in.

FV: For every anecdote I am sure you heard on the NPR piece, I have read or heard a similar anecdote from a banker who claims that they were threatened with government retaliation if they did not become more aggressive in making sub-prime loans with lower underwriting standards in low income communities. I am not – repeat – am not excusing the greed on behalf of the lending community that decided to go with the flow and exploit the situation. My point is that the flow was at least encouraged if not initiated by government policy.

As for Obama, I do not dislike him. But it seems that the markets dislike him immensely. It is unfortunate that none of his skills – which are impressive – are useful in this economic crisis we are in. Regardless of your political inclinations, you must recognize that Obama’s background could not have prepared him for where he now finds himself. John McCain would also be out of his element. This is when I wish Mitt Romney could have run as a Democrat and gotten himself elected. His skills would have been useful now and the markets would be responding to that in a favorable way. Thanks for your comment. I appreciate your views.

Mr. TML, I think the mortgage problem also be illustrated (casting doubt on your “red-line” theory of this housing/banking crash) in the vast seas of new housing developments in California’s central valley and Florida that are now worth maybe 50-75% of what they were at the peak. My brother bought a house outside of Sacramento in January 2007 for $430,000. He says his house is worth maybe $250,000, now. Multiply this appropriately. He’s a solidly middle class guy in his late 40s. No hinky loan–but he’s wondering if it makes sense to just walk away.

Ahead of the curve: I feel bad for your bother but his problem is radically different from those who cannot make their payments. Too many people treat their homes like investments then freak out when the value drops. Your home is not an investment. It is an asset in which the primary value is providing you shelter. If you are living there and making payments, what does it matter that the value drops? You are still receiving the shelter benefits. Sure, if you want to move but you have negative equity, that’s a problem. But it is not a problem that entitles anyone to government help.

FV – TML is correct. With all the gov programs out there to make houses “affordable” to anyone who could sign their name if a banker refused an application he/she personally could be sued along with the bank for discrimination.

@ MasterPo: I am sorry but I will have to strongly disagree with you; the main culprit for the housing/credit bubble of 2001-2007 is not the US government but the “great flow of cheap capital from Asia to the US which financed US deficit spending”. Don’t take that from me – the quote belongs to Niall Ferguson, Harvard history and business professor. You can find his whole interview in the April 2009 issue of Money magazin.
Ben Bernake strikes a similar note in his recent interview on CBS 60 Minutes: “(BERNANKE) Well, a lot of mistakes got made. No question about it.
But, you know, this was a much bigger thing than any single firm or
any single—individual over the last– dozen years or so, enormous
amounts of savings has flowed into the United States, and some other
industrial countries. That savings has come from China and East Asia.
It’s come from oil producers. And it has– and hundreds of billions of
dollars, it has come into our financial system. And, you know, that
would be great if we took that money and invested it wisely, and got a
high return. But instead, our financial system– didn’t– didn’t do a
good job. We had a regulatory system that was like a sandcastle on the
beach. When you had little small waves just lapping up against the
sand castle, everything looked good. But when you had a big breaker
come in, suddenly it– the system wasn’t strong enough to deal with
it.”
That’s pretty much the gist of NPR’s “The Great Pool of Money”
The Wall Street, mortgage brokers and banks could not resist the temptation for big profits and that’s how the subprime mortgage mess came to be. Here’s a 2007 article from Business Week about the CEO of WMC Mortgage, the sixth largest nonprime wholesale lender in the country in 2003 (and one of the lenders featured in “The Great Pool of Money”): http://www.businessweek.com/magazine/content/07_44/b4056074.htm. The article starts with: “Way back in 2004, when subprime mortgages were a can’t-miss proposition, Amy Brandt was a superstar. Her success in turning a struggling wholesale lender into a powerhouse that generated more than $1.5 billion in home loans a month caught the eye of executives at General Electric (GE ).”

Boy, she must have been really scared by the possibility of being sued…